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Having poor credit or no credit can be frustrating. It may make it difficult to qualify for a loan or even get an apartment lease. And improving your credit is challenging when you have limited options. That's where a credit-builder loan can come in handy.
With a credit-builder loan, the lender deposits the loan funds into a secured savings account for you while you make payments on the loan. During that payment period, the lender reports your payment history to the three major credit bureaus (Experian, TransUnion and Equifax), helping you build credit history. Once you make all the payments, you get the money.
You can get a credit-builder loan by applying through credit unions, some banks and even online lenders.
6 Steps to Getting a Credit-Builder Loan
Applying for a credit-builder loan is surprisingly fast and fairly simple. Follow these six steps to get a credit-builder loan:
1. Check Your Credit Reports and Scores
Even though credit-builder loans are designed for people with poor or no credit, lenders will usually still review your credit reports and scores before approving you for a loan. You should do the same. Find out where you stand by getting a free copy of your credit report.
2. Gather What You Need
Before completing the application, spend a few minutes gathering the necessary information and documentation. Each lender will have its own criteria, but you'll typically need to provide the following information:
- Pay stubs, tax returns or other proof of income
- A valid bank account number and routing number
- Social Security number
- Valid U.S. address
- Phone number
- Form of ID, such as a driver's license
- Monthly mortgage or rental payment
3. Figure Out Where to Get a Credit-Builder Loan
While you won't usually be able to apply for a credit-builder loan at large national banks, there are several different lenders that offer these loans:
- Credit unions: Many credit unions offer credit-builder loans, though you'll need to become a member before you apply. Credit unions, which are nonprofit financial institutions that return profits to members, typically offer low interest rates and favorable terms. Look for a credit union near you that you may qualify for.
- Banks: While most national and international banks do not offer credit-builder loans, regional and local banks often do.
- Lending circles: With peer lending circles, participants qualify for interest-free loans, and payments are reported to the credit bureaus. They offer a way to obtain no-interest loans whose payments are reported to the three credit bureaus, thus helping you build credit. The nonprofit financial marketplace Mission Asset Fund can help you find a lending circle in your area.
- Online lenders: Online lender Self Financial offers credit-builder accounts, in which you make payments toward a savings fund. It offers repayment terms as long as two years, and you'll pay a one-time sign-up fee of $9 to $15, depending on the loan amount.
4. Understand the Terms and Conditions of the Loan
Before agreeing to a credit-builder loan, make sure you review the terms and conditions. There are some factors you should keep in mind:
- Grace period: Some loans have a grace period, or a time period before you have to start making payments on the loan.
- Prepayment: Most lenders don't charge prepayment penalties. However, if you close your account ahead of schedule, you may lose out on months of payment history—the whole purpose for taking out the loan.
- Loan term: Make sure you're comfortable with the loan term and monthly payment. The payment should fit comfortably within your budget so there's no danger of missing one.
5. Apply for the Loan
Once you're comfortable with a lender, you can move forward with your application. In most cases, you can fill out an application online. Or, if you're working with a brick-and-mortar credit union or bank, you can submit your application in person. The application takes just a few minutes to complete.
6. Start Making Payments and Building Your Credit
Once your loan is in place, you can start making monthly payments. For the credit-builder loan to work as designed, it's essential that you make all of your payments on time. Your payment history accounts for 35% of your credit scores; miss just one payment, and your credit could suffer.
How a Credit-Builder Loan Works
When you take out a credit-builder loan, you're approved for a certain amount—usually $300 to $1,000—and you make payments on that amount for six to 24 months, depending on your specific loan's terms. You'll pay principal and interest on the loan, but you may get some of that interest back once you've completed your payments.
The longer the loan term, the more you'll pay in interest. However, you may decide that a longer term is worth it because you'll have a more affordable monthly payment. Remember that the point of a credit-builder loan is to build credit history, and you won't be able to do that if you set payments you can't afford.
Once you've repaid the loan, the lender will release the loan amount to you. That money is yours to use as you wish. You could use it to finance a big purchase, pay down other debt or build up your savings account.
Other Options to Build Credit
Credit-builder loans aren't for everyone. Luckily, there are other ways to build your credit if you have little or no credit history:
- Apply for a secured credit card: A secured credit card is like a credit card with training wheels. You provide a deposit, and that becomes your credit limit. This allows you to establish good credit habits, while providing lenders with a low-risk way to help you do it.
- Become an authorized user: If you have a financially responsible friend or relative with good credit, ask them to add you as an authorized user to their credit card account. You'll get access to that account's payment history, which could boost your score if the primary cardholder keeps the balance low and pays their bill on time every month.
Credit-builder loans can be excellent tools for building credit. However, make sure you understand how they work and what the costs are so you're not surprised by interest charges and other fees.